The Federal Reserve knows about asset bubbles. It has been living with the question since at least a cold December night in 1996 when Alan Greenspan publicly pondered about “irrational exuberance” in the run-up to the dot-com bubble.
Now the issue is front-and-center again for Fed Chairman Jerome Powell as stock markets have gyrated in recent days with headlines about astronomical gains for stocks with little or no business prospects.
Some analysts have been quick to point the finger at the central bank for creating conditions for the volatility with its ultra-easy monetary policy and massive monthly bond purchases that have greased the economy, especially since COVID-19 crippled growth.
The Dow Jones Industrial Average
rebounded Thursday after its worst selloff in three months as investors monitor volatile trading in shares of GameStop Corp.
AMC Entertainment Holdings Inc.
and others that underlined concerns about speculative excess. Online investors, fueled by group think from Reddit’s WallStreetBets Forum, have taken on hedge funds, and stock trading companies like Robinhood, TD Ameritrade and Interactive Brokers have halted purchases on such stocks.
Steen Jakobsen, chief investment officer for Saxo Group, said the Fed’s easy policy has repressed financial conditions to the point that the market is now “a betting market.”
Economists see things a bit differently. It is not the Fed that is creating the environment for bubbles — it is the economy itself, they say.
Although the picture is complicated by the pandemic, they argue that the U.S. economy and much of the world’s largest economies are trapped in a permanently low-interest rate environment given the excess of savings over investment, known as “secular stagnation.”
In this low-rate environment, many U.S. financial firms and investors are still seeking returns of 6%-8%. This leads to “search-for-yield” trading in financial markets.
The IMF has warned about the unintended consequences of central bank policies, including in their latest global financial stability report this week.
What’s the Fed’s view on all this?
Former Fed Governor Frederick Mishkin said people overestimate how much the U.S. central bank pays attention to the stock market.
In reality, the Fed keeps a closer eye, where spreads between between U.S. Treasury bonds and corporate bonds are now narrower than they were prior to the start of the pandemic.
“People can lose money. They can do stupid things. We have have bubbles — crazy things like what it happening with GameStop but that very rarely has a major effect on the economy,” Mishkin said.
And yet at his press conference Wednesday after the Fed’s regularly scheduled meeting on monetary policy, Powell was immediately peppered with questions on the speculative excess and big investor vs. little investor volatility. The market phenomenon dominates the financial media and mainstream news alike.
Powell said “monetary policy does play a role but the connection between low interest rates and asset values is probably something that’s not as tight as people think because a lot of different factors are driving asset prices at any given time.”
He pointed out to reporters that 9 million Americans remain out of work due the pandemic.
Carl Tannenbaum, chief economist for Northern Trust, said the Fed is also focusing more than in the past on helping struggling populations in the economy.
So when confronted with an economy that is far short of its goal of low employment, Powell made clear that he is going to focus on fundamentals over financial stability.
But the Fed has to grapple with the question of moral hazard. Is their policy rewarding risky behavior?
If there was a major global stock correction, policymakers around the world “would try to find a way to recover from that because it would be economically destructive,” Tannenbaum said.
“And that’s where you know these long-standing discussions about policy and moral hazard – what the objectives of policy should be,” he said.
“I’m just not sure we’ve resolved those,” Tannenbaum added.
Former Fed staffer Roberto Perli, who know works at Cornerstone Macro, tweeted that “tightening policy to ward off bubbles is like trading a sure worse economic outcome in the near term for MAYBE a better outcome in the future.”
Perli said the ongoing debate could focus on whether financial stability should be a Fed mandate or the task for another entity? And what tools should be given?
Tobias Adrian, head of the IMF’s capital markets division, has hope that the U.S. can breathe new life into the Financial Stability Oversight Council. It was established as part of the Dodd-Frank legislation to identify risks and threats in the market.
Tannenbaum is more skeptical, saying that the FSOC has proven unwieldy since it was formed in 2010.
There needs to be a serious conversation, Perli said, adding “never too late to start talking about it.”